FORECASTS & TRENDS E-LETTER
by Henry Rohlfs
February 6, 2024

Measuring Inflation: CPI vs. PCE

IN THIS ISSUE:

1. A Busy Week of Economic News

2. Different Measures of Inflation

3. How the Fed Measures Inflation

4. The 2% Inflation Goal

5. Rate Cuts Not Coming Soon

Outside of financial reporting, articles on inflation rates usually quote the Consumer Price Index, or CPI. But financial writers in-the-know will reference “the Fed’s preferred measure of inflation,” the Personal Consumption Expenditures price index, or PCE. Today we’ll take a look at the two measures of inflation, how they are determined and why the Federal Reserve prefers one over the other.

But before we dive in, let’s take a look at some of the economic news released last week. Punxsutawney Phil, the famous weather-casting groundhog, didn’t see his shadow last Friday, and so predicted an early spring. Let’s see if the economy looks as rosy.

A Busy Week of Economic News

What a week we had! The Federal Open Market Committee (FOMC) met, the January jobs report dropped and the final consumer sentiment survey for January was released by the University of Michigan.

The US economy added 353,000 nonfarm jobs in January, exceeding estimates of 185,000 jobs and up from December's upwardly revised 333,000 jobs, according to government data released last Friday. The unemployment rate remained at 3.7% for the third month in a row. 

Most of the jobs in January were added in professional and business services (74,000), healthcare (70,000), and retail trade (45,000). Average hourly earnings grew 4.5% year-over-year in January, up from 4.1% in December.

The latest jobs report comes after the FOMC continued to keep its benchmark federal funds rate at 5.25% - 5.5%. The Fed's decision marks the fourth straight meeting in which the central bank has opted to hold rates at the highest level in more than two decades. As I discussed on January 16, the Fed looks to lower rates three times this year, although probably occurring in the second half of 2024. Chairman Jerome Powell in his post meeting statement said a rate cut is unlikely to come by the group's next meeting in March.

The University of Michigan’s Index of Consumer Sentiment jumped nearly ten points to 79.0 in January, up from 69.7 in December. Consumers now feel assured that inflation will continue to soften. Sentiment has again begun to rise from its all-time low of 50 measured in June of 2022.

To quote U.S. News, “Consumers are happy, the stock market is near record highs, inflation is moderating and the labor market is defying all forecasts.” And with the Atlanta Fed’s GDPNow model showing GDP rising to 4.2%, it looks like the economy may continue to get better. What a change from the predictions of a recession a year ago!

Different Measures of Inflation

Now on to our main topic this week. Two different price indexes are popular for measuring inflation: the Consumer Price Index (CPI) from the Bureau of Labor Statistics (BLS) and the Personal Consumption Expenditures price index (PCE) from the Bureau of Economic Analysis (BEA). Each has two different groups of goods and services: a headline or overall measure and a core measure which excludes food and energy prices. Which one gives us the actual rate of inflation that consumers face? Headline inflation attempts to reflect the prices that households pay for a wide variety of goods, while core inflation shows less volatility. By the way, there are several other consumption expenditure measures published by the Federal Government, but for simplicity’s sake, we’ll just examine these.

Between the two indexes, the CPI tends to show more inflation than the PCE. But what’s the difference? It comes down to three main factors.

Owner-occupied housing. CPI uses the costs of acquiring and operating a house by its owner, while the PCE uses a rent index as the monthly cost of living in a house. In recent years, this component accounts for the largest difference.

Different index weights. CPI gives more weight to expenditures made by urban households. PCE consumption measures a broader range of expenditures, adding rural households and nonprofit organizations to its measure. There are also some minor differences in the time periods used by the two indexes.

Other factors. The indexes have some differences in their price components. One example is that the CPI includes a Producer Price Index component.

How the Fed Measures Inflation

We often see financial reports refer the PCE index as “the Fed’s preferred measure of inflation.” The FOMC actually focused on CPI inflation prior to 2000 but, after extensive analysis, changed to PCE inflation.

They did this for three main reasons. The weighting between expenditure categories in the PCE can change dramatically as people stop purchasing goods and services in some categories and move to others. The PCE also includes more comprehensive coverage of goods and services purchases. Finally, historical PCE data can be revised if the BEA finds it necessary to do so.

The Fed concluded that continued use of the CPI would cause them to over-adjust for inflation. PCE would become the standard.

But wait a minute, which PCE index – headline or core? An FAQ on the Federal Reserve website answers the question:

“Policymakers examine a variety of ‘core’ inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items.”

As we all have experienced – especially over the last few years – prices in the grocery store and at the pump can change substantially over a period of weeks. Since Fed policymakers must work with a lag in data, inflation indicators must be somewhat consistent over months. Price volatility could adversely affect an assessment of a long-term trend.

Because of these considerations, the Fed relies on the use of the core Personal Consumption Expenditures price index as its main inflation indicator. However, the Fed is quick to state that this is only one of dozens of economic indicators they use to formulate policy.

The 2% Inflation Goal

In January 2012, the FOMC formally adopted an explicit inflation target of 2% as measured by the annual change in the headline PCE price index. Why 2%? The committee interprets a 2% inflation rate as consistent with price stability. It also gives the Fed room to cut interest rates, if needed, while avoiding deflation.

The inflation target is meant to be reached over a longer period of time. It is important to note the Fed’s goal is not to hold inflation at a constant 2%. Former St. Louis Fed president Jim Bullard explained the period over which the FOMC would aim to hit the target.

“To clarify, this does not mean inflation must be 2 percent in the short term; rather, monetary policy should be set so that inflation moves toward the target over time and, in the absence of unpredictable changes in either supply or demand, would reach 2 percent in the medium term,” he wrote.

Rate Cuts Not Coming Soon

The core Personal Consumption Expenditures (PCE) price index rose to 2.9% year-over-year in December while headline PCE hovers at a 2.6% annual rate. The December Consumer Price Index (CPI) also rose to 3.9% annually. Core PCE is still above the Fed’s target rate of 2%.

Chair Jerome Powell essentially repeated his post-FOMC meeting press conference remarks on the CBS show 60 Minutes last Sunday. Inflation has come down. The economy is strong. The labor market is strong. We want to cut rates this year, but we want to see more good data before we do. This same message was echoed by other Fed Governors in the last week.

Maybe Chair Powell is the new groundhog. He emerged from his FOMC den last week, and the glaring sunshine of potential recession cast an ominous shadow. Powell had no choice but declare there would be six more months of higher-interest winter.

Don’t forget your booties ‘cause it’s gonna be cooooold out there a while longer.

All the best,

Henry

 

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